Friday, October 10, 2008

Earlier today, Jim Rogers' suggested course of action to help cure what ails financial markets was made clear in this Bloomberg interview where he channeled Andrew William Mellon, the Secretary of the U.S. Treasury from 1921 to 1932.

This "liquidationist" thesis, while considered an outdated concept today, may well be the most prudent course or action given where we are now, but it would certainly be quite unpopular and politically unacceptable.

Allowing everything to come tumbling down quickly so that it can be rebuilt in a more sturdy fashion and thus minimize the total quantity of pain that is delivered just doesn't seem to be a popular idea, likely due to the sad reality that most still believe that the financial system now crumbling around us was fundamentally sound.It wasn't - hasn't been for decades.

Economists and policy makers these days - even the most bearish ones - seem to be unanimous in their proposed solutions, nearly all of which contain the same critical element of requiring a "bigger bucket" to bail the water now gushing quickly into the ship.

- another rapid round of policy rate cuts of the order of at least 150 basis points on average globally;

- a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;

- a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;

- public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;

It seems the old analogy about firemen not worrying too much about water damage while putting out a fire would be appropriate here - better not to worry about what exactly is coming out of the fire hose.

In an op-ed piece in today's Wall Street Journal, former Federal Reserve Chairman Paul Volcker argued the tools are already in place to counter the current slide:

First of all, there is now clear recognition that the problem is international, and international coordination and cooperation is both necessary and underway. The days of finger pointing and schadenfreude are over. The concerted reduction in central bank interest rates is one concrete manifestation of that fact.

More important in existing circumstances is the clear determination of our Treasury, of European finance ministries, and of central banks to support and defend the stability of major international banks. That approach extends to providing fresh capital to supplement private funds if necessary.

In the U.S., with higher limits of deposit insurance in place, the FDIC has demonstrated its ability to protect depositors, to arrange mergers, and to provide capital for troubled banks. Most other countries now have a comparable capacity.

Recent U.S. legislation has provided authority for large-scale direct intervention by the Treasury in the mortgage and other troubled markets. Along with increased purchases by Fannie Mae and Freddie Mac, now under government control, means of restoring needed liquidity are at hand.

Here too, the thinking seems to be that if we just do much, much more of what we've been doing, somehow, things will turn out OK.

And Stephen Roach writes in the Financial Times from his perch in China:

Yesterday's rare co-ordinated easing by the world's leading central banks was an important step in the right direction. The risk is it may not have been enough.

This crisis is so grave and so threatening that it is critical that policy err on the side of overkill - not underkill. That is true of both monetary and fiscal policy alike.

I would have preferred to have seen rate cuts of twice the magnitude that were announced yesterday - leaving no mistake as to the power of the weapons being deployed as well as the collective resolve of the stewards of the global economy.

I would also have preferred a blanket statement to have been issued by the world's leading central banks that they are collectively prepared to backstop global liquidity in the broadest sense. This endorsement should also include the cash (but not derivatives) markets of counterparty risk.

If things do somehow stabilize in the period ahead and some sense of normalcy returns to markets next year, the inflationary impact of all the present and future "bailing" could be tremendous.

You thought $4 gasoline and $1,000 gold was bad?

The arguments of Jim Rogers and Andrew Mellon are starting to look smarter every day.

What's also looking like an excellent idea (in hindsight) is to have "pricked" a few of these asset bubbles over the last twenty-some years so their bursting wouldn't lead to what is unfolding today.

I keep thinking of new ways to look at this situations - it's like a bunch of different equations for which I need to find the value of x.

The problem is, x is "bankrupt United States" in every single one.

Have you ever tried shovelling 700 billion dollars onto a raging bonfire? Me neither, but you wouldn't be able to see the fire anymore. It would still be there, though, and eventually some smoke would seep up through the billions of dollars... and then, much later, you'd see a flame again, as the entire stack went up.

«Allowing everything to come tumbling down quickly so that it can be rebuilt in a more sturdy fashion and thus minimize the total quantity of pain that is delivered just doesn't seem to be a popular idea, likely due to the sad reality that most still believe that the financial system now crumbling around us was fundamentally sound.»

Well, people are against it because they have no safety net, and they still think that their paper wealth is wealth (the latter probably a secondary consideration).

The ideal solution to the crisis would be to allow liquidation of the financial system, without wasting a cent in it, and at the same time invest heavily into protection of the real economy, with better welfare, public investment, etc.; however corrupt and wasteful public spending may be, it cannot be quite as corrupt and wasteful as private financial investment.

«If things do somehow stabilize in the period ahead and some sense of normalcy returns to markets next year, the inflationary impact of all the present and future "bailing" could be tremendous.»

For the past several years I have wondered whether the gigantic credit bubble that started in 1995 would end in huge deflation or huge inflation, which depends on which of their paymasters politicians want to favour.

I suspect now that it will be *both*: a sharp short period of even harder wage and employment deflation followed by hyperinflation of asset prices again.

«There are awfully few solvent individuals, for that matter.»

But those few are *very* solvent. There is no lack of wealth and money in the USA today; it is still a capital-rich country. It is just that a lot of it has been concentrated in the hands of the few who have gamed the system to such tremendous advantage to themselves.